CHAPTER 1 An Overview of Financial Management

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What is Financial Analysis

• Financial analysis
• To evaluate and valuate.
• Evaluate determinants of financial performance
• Determine and put a value to performance
  parameters
• Make a decision

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Determinants of Financial Performance

• External Environment
• Financial System
• Financial sector
• The mechanics of moving resources
• Economic forces
• Industry factors
• Internal Environment
• Inputs, Operations, Outputs and supporting
  activities
• The various departments
• Corporate governance and agency problems
• Company risk and return
• The Future
• Forecasted cash flows
• Forecasted growth rates

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The Financial System

• The type of financial system that the company
  operates in has a great impact on its performance
  and value
• Less developed financial systems lead to lower
  economic growth hence, poor performance and
  lower value for operating companies
• The financial infra structure facilitates the
  movement of resources efficiently.
• Efficiency means availability at low cost.

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The UAE Financial System

• Although the Islamic culture is dominant, the
  financials system here is still a capitalist one.
• Such system has the following components
• Participants
• Financial sector
• Interest rates and money supply

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The Financial System
Financial System
I/M
Fin. Sec.
Participants
- Interest rates - Money Supply
- Government. - Businesses - Individuals -
Foreigners
- Financial Markets - Financial Institutions
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The Financial Sector
Financial Sector
Financial Markets
Financial Institutions
Long Term Equity Debt
Short Term Money FOREX
Non-depositories Investment Companies Securities
firms Contractual
Depositories Banks Credits Unions
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How Does It Work
Flow of Funds Through the Financial System
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Interest Rates and Money Supply

• Interest is the rent of money
• Equal to the real growth rate of GDP plus the
  expected inflation rate plus a premium to
  compensate for the riskness of the company being
  analyzed.
• Money supply is the amount of liquidity that is
  being allowed by the UAE central bank. The
  company being analyzed benefits if the amount of
  liquidity is near the healthy level.
• Both interest rates and money supply have a great
  effect on the performance and value of the
  company and need to be taken into consideration
  in any financial analysis.

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Technological change

• Inventions--new ideas or technologies
• Innovations--inventions that can be replicated
  reliably on a meaningful scale
• Company products may become obsolete due to new
  technological advances e.g. carbon paper

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Regulations

• Among the most significant determinants of
  organizational success
• Governments provide and enforce the rules by
  which organizations operate
• Level of interference from government varies from
  country to country and industry to industry
• The worldwide trend is towards deregulation and
  privatization
• In the UAE, significant political/legal influence
  comes from lawmakers and regulatory agencies
  nevertheless, considered liberal in the
  international arena.
• How the company under analysis is affected by
  legal changes is the purpose of regulatory
  analysis in the external environment

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Demographic changes

• Changes in the population mix and their needs.
• In the UAE a growing percentage of the population
  is foreign and from certain concentrated
  ethnicities. This will greatly affect the growth
  of the revenues and hence cash flows of the
  company being analyzed.
• Changes in the tastes and cultural influences.
• Religion is having a growing role in the UAE,
  this has a great influence on the textile
  industry, especially in women's wear.

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Political environment

• Security and stability has a great influence on
  the volatility of growth and cash flows.
• The UAE is a peaceful country and the government
  is stable via the support of its people. This is
  leading to the internationally noted growth.
• Peace and healthy relations lower the systematic
  risk of the country, hence lowering the cost of
  capital and increasing growth and value.
• Again, the UAE is known to have peaceful
  relations with its neighbors and the world, this
  is the reason for the growth of international
  business in the UAE as a source of international
  diversification.
• The global integration that is set by the new
  international order.
• The UAE was able to benefit from the new
  international order in many respects. The new
  steadily high oil prices, the new opening of
  international borders had also pumped the needed
  resources for the UAE and its companies to
  support the notable vast growth.

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Economic Indicators

• Leading economic indicators like inflation,
  unemployment, consumer confidence, labor
  productivity, level of interest rates, exchange
  rates, .
• In the UAE, other than moderate inflation
  pressures motivated by temporary real estate
  rental and property value, the LEI point towards
  solid and steady growth.

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Effect

• The effect of these determinants of growth, risk
  and cash flows, varies from one entity to
  another. For, instance, peace times are not good
  for weapon manufacturers. Times of economic
  growth are not good for inferior goods producers.
  
• In essence, one needs to be careful when
  analyzing a company for the purpose of
  determining its financial performance and value.

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Industry Factors

• The five forces that impact a companys ability
  to compete, grow and add value in a given market.
• Rivalry
• Entry
• Substitutes
• Suppliers
• Customers

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Rivalry

• Lower prices, higher advertising costs, extended
  warranties, payment facilities, higher quality,
  product improvements and new products. All
  costly, may increase growth, but will lower cash
  inflows and increase risk.
• In the UAE, competition is wide open amongst
  domestic firms and with international ones.
• The intensity of rivalry happens when
• Competitors are equal in size and abilities
• Slow growth industry
• Lack of differentiation
• Lack of switching costs
• High exit barriers
• Large number of competitors
• In the UAE, for most industries (excluding
  Laundromats and the likes) and due to fast growth
  in demand, rivalry is not very intense but is
  expected to be so in the near future.

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Entry

• Factors that limit entry to industries are
• Economies of Scale and Scope
• Government policies
• Expected retaliation
• Product differentiation
• Switching costs
• Capital requirements
• Access to distribution channels
• Financial analysts need to look at these factors
  to figure out whether new entrants to the
  industry are likely and whether they will
  increase the intensity of rivalry and to assess
  its effects on growth, risk, cash flow and value.

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Substitutes

• Now and in the future
• Examples would be electronic security systems
  instead of security guards.
• Existence of good substitutes has a great effect
  on the pricing of products and hence on growth,
  risk and cash flows of the company being
  analyzed.

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Suppliers

• Suppliers can affect cost and hence affect the
  growth and cash flows, especially when the
  product is price elastic.
• Suppliers are capable of driving down value if
• The number of suppliers is small
• We are not large
• The needed product does not have good substitutes
  and is an important component of our final
  product
• High switching costs
• The supplier can produce the final product easily
  and enter the market as a competitor.

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Customers

• Customers can affect revenue and hence affect the
  growth and cash flows, especially when the
  product is price elastic.
• Customers are capable of driving down value if
• The number of buyers is small
• We are not large compared to the number of buyers
  or the volume of product needed
• The needed product has good substitutes and is
  not important
• Low switching costs
• Buyer has full information and can choose between
  products.

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Internal Analysis

• Analyzing the company as a whole and by
  department especially the finance department to
  evaluate its performance and to prepare financial
  information for financial analysis.
• Human resources
• Knowledge and learning resources
• Physical resources
• General organizational resources
• And most importantly financial resources
• Financial analysts do visit companies and can ask
  questions and inspect operations physically.

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Human Resources

• Managers CEO and top management team
• Employees recruitment, training programs,
  rewards system
• Owners/board of directors

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Knowledge and Learning Resources

• Organizational learning leads to strengths in
  other resource areas. It involves
• Knowledge creation
• Knowledge retention
• Knowledge sharing
• Knowledge utilization

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Physical Resources

• Tangible resources such as machinery, plants and
  products easy to imitate, but the processes to
  create them are not
• Locations competitive clusters can provide
  advantages to companies and consumers

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General Organizational Resources

• Some general organizational resources are hard to
  imitate and are therefore excellent sources of
  sustainable competitive advantage
• Organizational reputation
• Corporate brands
• Unique configurations of stakeholder
  relationships joint venture, long-term
  contracts and other types of partnerships and
  alliances
• Organizational structure and internal systems
• Organizational culture

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Financial Resources

• Strong cash flow, low levels of debt, strong
  credit rating, access to low interest capital and
  reputation for creditworthiness can increase
  strategic flexibility more responsive to new
  opportunities.
• Diagnose problems
• Declining profitability
• Insufficient liquidity
• Leverage too high or too low
• Internal mismanagement
• Essential comparisons
• Firm to competitors
• Firm to itself over time

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Some Commonly Used Ratios

• Profitability
• Gross Profit Margin
• Net Profit Margin
• ROA
• ROE
• Liquidity
• Current
• Quick
• Leverage
• Debt to Equity
• Total Debt to Total Assets (Asset Ratio)
• Activity
• Asset Turnover Average Collection Period
• Accounts Receivable Turnover Inventory Turnover

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The Value Chain

• Primary Activities
• Inbound Logistics
• Operations
• Outbound Logistics
• Marketing and Sales
• Service
• Activities that Support the Primary Activities
• Administration
• Technology Development
• Human Resource Development
• Procurement

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Corporate Governance

• Corporate governance is the system by which
  business corporations are directed and
  controlled. The corporate governance structure
  specifies the distribution of rights and
  responsibilities among different participants in
  the corporation, such as, the board, managers,
  shareholders and other stakeholders, and spells
  out the rules and procedures for making decisions
  on corporate affairs. By doing this, it also
  provides the structure through which the company
  objectives are set, and the means of attaining
  those objectives and monitoring performance.
• Of great importance in financial analysis and due
  to their effect on performance and value are the
  following relations
• Board of Directors
• Managers
• Auditors
• Regulators
• Market for corporate control

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Board of Directors

• The board of directors
• Hires, fires, supervises and compensates top
  management
• Approves major strategic decisions
• Ensures that the firm and its managers are acting
  responsibly
• Provides advice to top management
• Provides a social network that helps firms
  acquire resources
• Factors that determine the success of the board
  to create value
• Institutional Vs. Individual
• Shareholder Vs. External
• Men Vs. Women
• Educated Vs. Not Educated
• Old Vs. Young
• The strength of the board is a major factor in
  assigning a discount rate and in assessing growth
  and cash flow forecasts.

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Manager Shareholder

• Agents--managers with a fiduciary duty to act in
  the best interests of owners
• Agency problem--managers maximize their own
  self-interests at the expense of owners
• High salaries of CEOs
• Emphasis on short-term performance at expense of
  long-term performance
• Empire building for status
• perquisites
• The burden is to align the interests of the
  manager with those of the shareholders
• This puts a DRAIN on the performance and value of
  the firm.
• Tactics used to align interest
• Manager part owner
• Stock options
• Bonuses
• Cash dividends
• Debt
• Monitoring
• Corporate control markets

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Shareholder Debt holder

• The conflict of interest arises here when the
  firm is over indebted.
• Shareholders will get into high risk high
  return investments, if such investments
  materialize, shareholders will reap most of the
  benefit (debt holders are paid a fixed percentage
  and the residual goes to the shareholders), if
  not most of the loss will be on the side of the
  debt holders.
• The solution is covenants
• The financial analyst needs to assess such
  situation in the process of determining a risk
  premium among other things.

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Shareholder - Shareholder

• A rises in companies with subsidiaries and
  affiliates
• The interests of the subsidiary shareholders are
  not in line with those of the shareholders of the
  parent companies
• Appears in capital budgeting decisions especially
  when the parent and the subsidiary are in two
  different tax and regulatory regimes

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Auditors

• Auditors are prone to be lenient in auditing
  financial statements and in valuing business
  because they are paid by the very same party they
  are auditing or do not want to lose future
  business opportunities.
• Such considerations need to be taken into account
  when financially analyzing a firm.

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Regulators

• The regulators interests may be different from
  those of the company being analyzed
• The regulator may enact regulations that hurt the
  company for the public good levying taxes is an
  example.

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The Market for Corporate Control

• Participants in the financial markets are
  monitoring each other to capitalize on
  opportunities of buying an undervalued firm.
• Firms that have corporate governance problems are
  prone to incur higher rate of return due to the
  risk premium added from such problems.
• The financial analyst needs to incorporate such
  factors in estimating and forecasting required
  rates of return and future cash flows.

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Company Risk and Return

• The analyst needs to incorporate specific
  analysis of the riskness of the company to
  reflect that on the required rate of return on
  investing sums of money in such company.
• Many measures of risk, the most important ones
  are the most simple ones, because they are the
  ones used most in industry practice.
• Beta
• Sigma
• VaR
• Many more like down side risk, coefficient of
  variatuin, regressions, time series, FF two
  factor model, FF multi factor models, Merton
  intertemporal model, stochastic models, stress
  tests under various distributions ..

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Types of Financial Analysis

• Fundamental use of all relevant information and
  to predict value assumes markets efficiency.
• Technical use of past price, trading volume and
  people behavior to predict value assumes market
  inefficiency.
• Naïve Financial ratios and some calculated
  indicators limited usefulness.

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Fundamental Analysis

• The value of an asset is equal to the present
  value of all of its future net cash flow.
• Need to take previous factors into account when
  forecasting cash flows, growth rates and required
  rates of return.

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Is stock price maximization the same as profit
maximization?

• No, despite a generally high correlation amongst
  stock price, EPS, and cash flow.
• Current stock price relies upon current earnings,
  as well as future earnings and cash flow.
• Some actions may cause an increase in earnings,
  yet cause the stock price to decrease (and vice
  versa).

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Factors that affect stock price

• Projected cash flows to shareholders
• Timing of the cash flow stream
• Riskiness of the cash flows

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Basic Valuation Model

• To estimate an assets value, one estimates the
  cash flow for each period t (CFt), the life of
  the asset (n), and the appropriate discount rate
  (k)

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Dividend Discount Models

• Constant growth
• Two growth
• Multi growth
• Stochastic
• Additive w and w/o bankruptcy
• Geometric w and w/o bankruptcy

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Multipliers

• PE
• PB
• V/EBIT
• P/S
• P/CF

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Forecasting Example
Balance sheet, in millions of dollars
Cash sec. 20 Accts. pay. accruals
100 Accounts rec. 240 Notes payable
100 Inventories 240 Total CL 200 Total
CA 500 L-T debt 100 Common stock 500 Net
fixed Retained assets 500 earnings
200 Total assets 1,000 Total claims 1,000
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Forecasting Example
Income statement, in millions of dollars
Sales 2,000.00 Less Var. costs
(60) 1,200.00 Fixed costs 700.00 EBIT
100.00 Interest 16.00 EBT
84.00 Taxes (40) 33.60 Net income
50.40 Dividends (30) 15.12 Addn to RE 35.28
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Key assumptions

• Operating at full capacity in 2006.
• Each type of asset grows proportionally with
  sales.
• Payables and accruals grow proportionally with
  sales.
• 2002 profit margin (2.52) and payout (30) will
  be maintained.
• Sales are expected to increase by 500 million.
  (GS 25)

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Determining additional funds needed AFN

• AFN (A/S0)?S (L/S0) ?S M(S1)(RR)
• (1,000/2,000)(500)
• (100/2,000)(500)
• 0.0252(2,500)(0.7)
• 180.9 million.

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How shall AFN be raised?

• The payout ratio will remain at 30 percent (d
  30 RR 70).
• No new common stock will be issued.
• Any external funds needed will be raised as debt,
  50 notes payable and 50 L-T debt.

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Forecasted Income Statement
2006
Forecast Basis
2007 Forecast
Sales 2,000 1.25 2,500 Less VC 1,200 0.60 1,50
0 FC 700 0.35 875 EBIT 100
125 Interest 16 16 EBT
84 109 Taxes (40) 34 44 Net
income 50 65 Div. (30) 15 19 Add
n to RE 35 46
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Forecasted Balance Sheet (2007) - Assets
2007 1st Pass
Forecast Basis
2006
Cash 20 0.01 25 Accts.
rec. 240 0.12 300 Inventories 240 0.12
300 Total CA 500 625 Net FA
500 0.25 625 Total assets 1,000 1,250
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Forecasted Balance Sheet (2007) - Liabilities
and Equity
2007 1st Pass
Forecast Basis
2006
AP/accruals 100 0.05 125 Notes payable
100 100 Total CL 200 225 L-T
debt 100 100 Common stk. 500 500 Ret.earnings
200 46 246 Total
claims 1,000 1,071
From income statement.
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What is the additional financing needed (AFN)?
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• Required increase in assets 250
• Spontaneous increase in liab. 25
• Increase in retained earnings 46
• Total AFN 179
• NWC must have the assets to generate forecasted
  sales. The balance sheet must balance, so we
  must raise 179 million externally.

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How will the AFN be financed?

• Additional N/P
• 0.5 (179) 89.50
• Additional L-T debt
• 0.5 (179) 89.50
• But this financing will add to interest expense,
  which will lower NI and retained earnings. We
  will generally ignore financing feedbacks.

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Forecasted Balance Sheet (2007) - Assets
2007 1st Pass
2007 2nd Pass
AFN
Cash 25 - 25 Accts.
rec. 300 - 300 Inventories 300 - 300
Total CA 625 625 Net FA 625 -
625 Total assets 1,250 1,250
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Forecasted Balance Sheet (2007) - Liabilities
and Equity
2007 1st Pass
2007 2nd Pass
AFN
AP/accruals 125 - 125 Notes payable
100 89.5 190 Total CL 225
315 L-T debt 100 89.5 189 Common
stk. 500 - 500 Ret.earnings 246 - 246
Total claims 1,071 1,250
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Advanced Forecasting

• Use of regressions for each item
• Use of iterations in finding interest income and
  expense
• Forecasting with stock dividends, stock
  repurchase, stock issuance, stock splits, .

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Technical Charts

• Point and figure
• Candlesticks
• OHLC
• Price lines
• Moving averages

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Technical Indicators

• Candlesticks hammer, bullish engulfing, morning
  star, bearish engulfing, hanging man, harami,
  Marubozu, three white soldiers, . Many more.
• Technical indicators moving averages,
  exponential moving averages, Bollinger bands,
  slow stochastic, fast stochasitc, Trin, Trix,
  Money flow index, RSI, Average directional index,
  Williams R, Price rate of change, Oscillators,
  . Many more.

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Use of Mathematics

• Not at this time
• Just for fun

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Exotic Financial Analysis

• Stochastic models in forecasting items and future
  interest rates and discount rates, and the
  previously mentioned stochastic dividend discount
  models.
• Real Options
• Abandonment Options